Retail Leads In CMBS Deals

Retail assets were responsible for the biggest share of CMBS deals in the United States in 2005 and boasted the lowest delinquency rate of all property types. The sector's strength, coupled with strong investor demand, resulted in higher leverage deals and tightened spreads.

But that may change soon. Industry experts suggest the retail CMBS market could be hurt this year by a possible increase in development and decrease in consumer spending. Moreover, bond buyers are starting to push back against the higher leverage and preponderance of interest-only loans in the retail sector, and spreads will likely widen.

“The retail sector has been getting a significant amount of sponsorship,” says Lisa Pendergast, managing director of real estate finance for RBS Greenwich Capital. “Retail makes up 30 percent to 35 percent of all the fixed-rate CMBS deals because it's an asset class that has performed well and is favored.”

CMBS favored retail

During 2005, roughly $250 billion of CMBS deals were completed, according to Standard & Poor's. Of that, retail mortgages totaled about $83 million, says Larry Kay, director of structured finance ratings for S&P. “Retail was probably the top contributor (of all the various property types) in 2005,” he says, pointing out that billions of dollars worth of retail assets changed hands last year because investors were attracted to the sector's strong fundamentals, and many of those buyers tapped the CMBS market for loans.

Retail properties have enjoyed substantial gains in property valuations during the last three years with the one-year appreciation returns for NCREIF's retail index reaching 6.38 percent, 12.54 percent and 14.30 percent in the third-quarters of 2003, 2004 and 2005, respectively. In the same time, cap rates have fallen from 8.3 percent to 6.6 percent.

“Cap rates in retail have gotten so low there are concerns that they will trigger development,” Pendergast says. “We've now reached a point where the success of the sector could hurt it.”

The national retail market is in better shape than other sectors, outperforming office, industrial and multifamily, according to industry experts. Wachovia Securities, found in a recent study that retail effective revenue had the least volatile growth of the sectors from 1989 to 2005, says Tony Butler, vice president and senior CMBS analyst with the Charlotte, N.C.-based investment bank.

The national retail vacancy rate rested at just 7 percent at the end of the third quarter, according to REIS. Absorption during the first nine months of 2005 reached nearly 27 million square feet, and the pace of new construction remained modest with 23.9 million square feet added during that time. Effective rents also increased, rising to $16.61 per square foot in the third quarter, compared with $16.24 per square foot in 2004, REIS says.

This year, vacancies are expected to climb slightly as construction increases to 37.1 million square feet of retail completions as retail sales slow, according to John Levy, author of the Gilberto-Levy Index and president of Richmond, Va.-based John B. Levy & Co. Inc. “While consumers have been exceptionally resilient to date, the outlook does call for slower retail sales,” he says.

Spreads widen

In addition to concerns about the future performance of the retail sector, the amount of leverage used in retail CMBS deals is starting to draw attention. Although Pendergast points out that the amount of leverage for all CMBS deals has been stagnant at 69 percent for several years, the valuation of properties has increased substantially.

But rating agencies such as Moody's and S&P report that leverage has increased from 90 percent in 2002 to 97 percent in 2005. It's worth noting, though, that the ratings agencies are referring to the stressed loan-to-value, which is calculated using the issuer's cash flow and a higher cap rate. The agencies' calculations typically cause the LTV to increase beyond the real leverage of 85 percent to 90 percent.

“The rating agencies have said that assets have loans at 100 percent or more,” Levy says. “That's true (based on their calculations), but also somewhat misleading because the agencies are trying to appraise things consistently using a higher cap rate and the market is valuing properties in a very aggressive manner.”

Pendergast notes that the rating agencies calculated that 73 percent of CMBS loans in 2005 had stressed LTVs of more than 90 percent, compared with just 42 percent of the CMBS deals in 2002.

The aggressive valuations and resulting market frothiness caused spreads to widen in late 2005, according to Manus Clancy, managing director of Trepp LLC, a New York-based CMBS research firm. “Deals are starting to get criticized, and bond spreads are widening,” he says.

However, spreads for retail CMBS loans have been tightening for the past five years, Pendergast points out. The average rate for a retail loan is about 125 bps to 150 bps over 10-year Treasuries, compared with 250 bps over Treasuries in 2001.

The higher leverage and preponderance of interest-only loans, however, is creating some concern among B-piece buyers, according to Shane Tucker, managing director of Prudential Real Estate Investors. “We're starting to feel some push-back from them because they feel exposed,” he says.

The biggest change in bond pricing has been in BBB and BBB minus bonds, where spreads are 25 bps to 30 bps tighter than they were in late 2005, reaching swaps plus 125 bps for BBB and 175 bps for BBB minus. “Spreads have widened because investors feel they need to get more money for this level of risk,” Clancy explains.

Even the spreads on A-rated bonds have widened, with AAA bonds selling at swaps plus 31 bps, which is six or seven bps wider than lowest rate. Moreover, the all-in-cost of these deals is 10 to 12 bps wider and the increased prices will be passed down to the borrowers in 2006. “The next wave of lending to retail borrowers will probably come at a higher spread than they've become used to,” Clancy predicted.

“Bond buyers might be more wary of retail CMBS in the future because of the expectation of more delinquencies,” says Sally Gordon, senior vice president of structured finance for Moody's Investors Service.

In the third quarter, the amount of rated CMBS that was delinquent increased slightly to $3 billion after four quarters of consecutive declines, according to S&P. In fact, all major property types, except for retail, experienced greater delinquencies.

S&P's Kay notes that retail continues to boast the lowest delinquency rate of all the major property types at 0.28 percent — a 14 bps decline from last quarter. As of September 2005, $310 million worth of retail CMBS were delinquent.

The retail delinquency rate at the end of 2005 was at its lowest point since 2000, Kay points out. But it is not equal. Most losses within the sector are with outlet centers. Surprisingly, there are a few regional malls in default. “It's rare for this to happen,” Kay notes. Simon Property Group Inc., for example, has two malls in default — the 500,000-square-foot Biltmore Square Mall in Asheville, N.C. and the 180-store Century III mall in West Mifflin, Pa., near Pittsburgh. Both malls are in tertiary markets, and Simon indicated that the trade areas could not support malls of this size.

“A tertiary market is typically a red flag because it all comes back to population and income growth,” contends Tony Butler, vice president and senior CMBS analyst with Wachovia Securities. Kay expects to see more delinquencies this year and in 2007, primarily because retail sales are projected to decline. “We're more cautious about delinquencies due to additional supply coming online in 2006 and 2007,” he says.